Stock market investment risk will not reduce “over the long term”!

The mutual fund industry has a simple sales mantra. Tell investors not to worry about market volatility because everything will turn out okay in the end! Even the NSE said market volatility is temporary! Thanks to a largely ignorant media, investors are fed on a constant diet of “don’t stop your SIPs if you want to grow wealth”. Sorry, stock market investment risk will never reduce for meaningful “long term” investment durations.

To get this, we look at every possible 5,6,7,…33,34,35 year return period for the Sensex, compute return, pull out and plot the lowest (min) and highest (max) return. This is return spread is a simple way to understand stock market risk. This is an “excellent” graph for a mutual fund distributor to use. Hey, look at that max, and min return lines merge “over the long term”. This is why you should keep your SIPs running.

Recall this quote?

if you torture the data long enough, it will confess to anything

Well, the truth is that you do not need to go into all that trouble. Just reduce the sample size and often you get the result that you want. In this case, the sample size is the available stock market history. We have data only from 1979.

To claim something as dramatic as “stock investment risk reduces with time” we need data going a lot further back in history (assuming we want the truth and not a slide to sell). So let us take a look at S& P 500.

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I could not get daily total returns data from 1927, a comparison of the above and below graphs would tell you that it does not matter much. At first sight, you would argue that stock market investment risk does reduce over the long term.

Hang on. Less than 5-year return spreads dominate the graph. So let us get those out of the way. Now, look carefully.

Even with dividends, negative returns are possible up to two decades of investing! Yes, yes, the gap between the max and min returns decreases. However:

The drop is only from 5 to about 27 years.

Even at 15, 20, 25 years, the spread in returns is too high. Yes, the risk is lower than say five years, but it is not small enough to blindly keep investing! Ever heard of the saying, “a miss is as good as a mile”?

Now for the critical observation: Notice that the gap bet max and min returns from years 27 to 55 y is pretty much the same.

Points one and two above should be enough to convince an investor that “long term investing” is not less risky – at least as it is marketed. Point 3 is proof for the unbiased analyst.

Please do not ask “what is the probability of a positive or negative return over the long term?”. Such things cannot be computed. Well, they can be, but it has no meaning.

Also (2), India is not different! We live in an interconnected world. A recession in other countries will spill over to us and dent “long term return expectations”. So the picture shown above for Sensex is likely to change into the one for S & P 500. At the very least, a good risk manager would expect that.

When people read such posts, they assume I am trying to scare people away from equity. I gain nothing from it. I am merely trying to point out that merely dreaming that investing each month will lead to wealth and inflation-beating returns is unfounded. Any portfolio linked to the market must be managed systematically.

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M. Pattabiraman(PhD) is the founder, managing editor and primary author of freefincal. He is an associate professor at the Indian Institute of Technology, Madras. since Aug 2006. Connect with him via Twitter or Linkedin Pattabiraman has co-authored two print-books, You can be rich too with goal-based investing (CNBC TV18) and Gamechanger and seven other free e-books on various topics of money management. He is a patron and co-founder of “Fee-only India” an organisation to promote unbiased, commission-free investment advice. He conducts free money management sessions for corporates and associations on the basis of money management. Previous engagements include World Bank, RBI, BHEL, Asian Paints, Cognizant, Madras Atomic Power Station, Honeywell, Tamil Nadu Investors Association.For speaking engagements write to pattu [at] freefincal [dot] com

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